Prof. Michael S. Knoll on the debate over “competitiveness” and tax policy

October 31, 2012

Recently, the car rated “most American made” for the third year in a row was not a Ford or Chevy, but the Toyota Camry, a vehicle assembled at plants in Kentucky and Indiana. In fact, four of the top five “most American made” cars in Cars.com’s 2012 annual survey are manufactured by Toyota or Honda in U.S. plants that employ American workers and source most of their parts from U.S. factories.

So do tax policies favorable to Toyota, Honda and other foreign-owned companies doing business in the United States contribute to or detract from American competitiveness?

Understanding what is meant when invoking the term “competitiveness” is important, Knoll says, because “politicians on both sides of the aisle are promising to improve U.S. ‘competitiveness’ and are targeting reform of the tax system as part of the solution, without being clear about what they mean and without recognizing that different reforms are appropriate depending upon how ‘competitiveness’ is defined.”

In the context of debates over international tax policy, “competitiveness” has two distinct meanings, according to Knoll, the Theodore K. Warner Professor of Law and Professor of Real Estate and co-director of the Law School’s Center for Tax Law and Policy.

One definition focuses on how taxation affects the ability of firms to compete around the world. In this meaning, competitiveness involves the total output (both domestic and foreign) of companies based in the U.S., like Ford and GM.

In contrast, the second conception of competitiveness focuses on the total output of a particular industry doing business in the U.S., without regard to the nationality of the producing company. Under this definition, Toyota and Honda are part of the U.S. auto industry and the cars they make here contribute to American competitiveness.

“Neither conception of competitiveness or definition of the U.S. industry is right or wrong,” Knoll writes. “Both conceptions of competitiveness are plausible as are both definitions of the U.S. industry.”

But the contrasting definitions have different implications for tax policy.

“Each conception of competitiveness is associated with a specific way of defining the domestic industry and a different mechanism through which taxation affects the competitiveness of that industry,” Knoll writes.

Under the first definition, focusing on the global operations of U.S. based car companies like Ford and Chevy, tax policy promotes competitiveness when it makes it easier for U.S. firms to compete with firms from other countries for foreign assets, such as overseas factories and the ability to hire foreign workers. Under this definition, “competitiveness” is not harmed by high U.S. corporate tax rates relative to foreign corporate tax rates, but it is adversely affected by policies that tax U.S. corporations on their foreign earnings.

Under the second definition, focused on total car production in the U.S., whether by Ford or Toyota, tax policy increases competitiveness if it encourages investment in American production facilities. Under this definition, U.S. competitiveness is harmed by relatively high U.S. corporate tax rates.

Knoll observes that the two views map onto well recognized positions in longstanding policy debates about whether and how much company ownership matters.

In 1990, Robert Reich, who would later become President Bill Clinton’s Labor Secretary, published a famous article in the Harvard Business Review entitled “Who Is Us?” In it he argued that U.S. policy should not seek to promote U.S. corporations, but should instead encourage international investment into the U.S. in order to create jobs and raise wages. Laura D’Andrea Tyson, who would later chair President Clinton’s Council of Economic Advisers, responded by arguing that the competitiveness of the U.S. economy remains tightly linked to the competitiveness of U.S. companies and that government policy should to some extent support U.S. owned firms.

Reflecting on that debate and its current resonance, Knoll observes: “Both ways of thinking about the connection between taxation and competitiveness are intuitive and both are based on conceptions of competitiveness that have deep roots in the economics literature going back for many years.” He concludes that only by carefully defining what is meant by competitiveness and thoroughly examining how international taxation affects a well-defined conception of competitiveness can policies be formulated to promote prosperity.